July 8, 2007

World’s financial community gives two fingers to the US

Investors can now see through the Americans’ game. Since 2000, the US has been playing a big game of IOU with the rest of the world. They spend more than they save, and they’re asking us to bridge the gap.

On the day the Irish media was focused on the consummation of the Fianna Fail/Green Party marriage, an event of considerably more importance for this country received little coverage. Yet this event is likely to have more significant and longer-lasting ramifications for us than anything this new government gets up to.

On June 15, the US government was given two fingers, not by a bunch of internationalist lefties, but by its main supporters, the international financial community.

The US treasury tried to sell new US ten-year treasury bills worth $8 billion to plug the gap between what Americans spend and what Americans save. For the first time ever, foreigners said: ‘‘No thanks.”

In doing so, foreign investors kicked off a process that has left the financial markets and the dollar in a tizzy. By taking up only 10 per cent of what the US government was trying to sell, investors have screamed: ‘‘The emperor has no clothes!”

They are beginning to see through the Americans’ game. Since the beginning of the century, the US has been playing a big game of IOU with the rest of the world.

Americans have been spending more than they are saving, and are asking the rest of the world to pay for the gap. In return, the US gives us a piece of paper which states that the American government will pay us back in 30 years.

For these pieces of paper to hold their value, the US should now be reining in spending, to send a signal to the creditors that it is over the hump and will now be a good boy and stop buying all those SUVs with other people’s cash.

But the US has done precisely the opposite. It has continued issuing pieces of paper in return for real money. This scam is only a problem if foreigners lose confidence in the US’s ability to pay – or in the US’s bona fides.

Up to now, the world has taken the Americans at their word. But that has now changed and the financial markets are getting fed up with the flood of paper promises coming out of the US.

Investors are now saying that they will only finance the US if either (a) the dollar falls dramatically before – not after – they lend money to the Yanks or (b) the rate of interest the Americans are prepared to pay rises considerably.

Both demands are bad for the US, which stopped making stuff a long time ago and now is a nation that buys and sells houses to each other, using other people’s money.

If the rate of interest has to rise, then the American housing market – which is already feeble – will be further weakened.

We are aware that the sub-prime mortgage market in the US is a mess. Any further rate rises and there will be a real risk of contagion in the swankier parts of the American housing market.

All this nervousness has an impact on US spending because the average man’s willingness to put his hand in his pocket is a function of, among other things, the equity in his house.

As the wealth effect associated with the housing market diminishes, American main street spending will also fall.

This traditionally is bad news for the rest of the world, and particularly for a trading nation like Ireland, because the Americans are our greatest trading partners.

(In recent years, research has disputed the influence of the US on the rest of the world. For example, an article in the latest IMF World Economic Outlook argues that the world today might not be as prone to catching a cold when America sneezes. Time will tell. Visit www.imf.com if you are into that type of stuff.)

What would be unambiguously bad news for Ireland is if the yawning gap between American spending and saving led to a run on the dollar, as many in the financial markets expect. This would make Irish costs look ridiculously high at a time when US multinationals are looking around the globe for places to invest.

Recently, I visited China. If anyone still doubts the impact that this giant will have on manufacturing businesses around the world, a day in Shanghai will leave you with no illusions. Not only is China capable of producing labour-intensive, low rent stuff, but in the high-tech sector, it is on the move.

Every major manufacturing brand is there, and the economic model for the future must be ‘‘make stuff in China, brand it in the US, sell it in Europe and America’’. Nothing else makes sense for a global manufacturer.

Sitting in the Blarney Stone pub in Shanghai, I got chatting to a bloke from Dublin who was a quantity surveyor.

Over pints, he told me that he had been based in the US for a few years but was now overseeing the building of the largest Intel plant in the world which the US multinational was about to build in Dalian, a city in northern China (where many of our immigrants come from).

Intel sees the opportunity in China and, at $200 a month for a highly-skilled technician, it is not hard to see how Leixlip or any other Intel ‘‘fab’’ might begin, over time, to look like an indulgence.

If the dollar were to fall, that indulgence might become intolerable. The same equation is being worked out in every corporate headquarters around the globe.

Now let’s get back to theUS and its financing needs. The world looks like it is going to be divided between countries that make hard stuff and countries that make paper money. The English-speaking world is in danger of being that part of the world that issues IOUs and prints paper money to pay for it.

Think about Ireland. In 2000,we had a healthy balance of payments surplus. We were saving much more than we were spending. This year, we are on course to have a deficit of close to 5 per cent of our GDP. We are borrowing close to â‚¬10 billion to plug the gap.

Just like the Americans, we are involving ourselves in a confidence trick. But unlike the Americans, who can and will devalue their currency to inflate their way out of debt, we, as inhabitants of the eurozone, do not have that option.

The only way we can pay for ourselves is by regaining competitiveness the old-fashioned way – via a long, painful recession characterised by levels of unemployment that many of today’s workforce have never experienced.

Now that the financial markets have wised up to the US game, how long before the markets focus the attention of the corporate world on the similar antics of America’s little cousin across the Atlantic?

The American’s are already in recession, its not reported yet since their official government statistics have been compromised. There has been a steady decline in the value of the dollar for many years now, more recently several countries have been cutting their links with the US currency and the decline will pickup steam after after the Chinese Communist party (sic) congress in the Autumn. With the mass baby boomer retirement beginning the US government has no choice but to inflate their currency in order to meet their prior commitments. We’re also in the peak oil/gas zone right now, with no extra refining capacity to meet current demand in the USA or Europe. 2008/2009 will see the effects of a long decline in the Anglo-Saxon economies as more power shifts to Russia and China.

David,
some reports claim that as much as 500 billion dollars per year are injected into the US financial system from the international illicit drugs trade. Assuming that this figure is approximately correct, could this great resource of cheap finance be a factor in the performance of the US financial markets over recent years?
regards,
CM.

Good stuff David,
It’s amazing how many of our economists working for some of the major financial institutions seem surprised with current economic data in Ireland. We have been following the economic trend of the US with a time lag of 18-24 months.
The only thing is I do believe that the powers that be in the US realise the stage of the economic cycle they are in and are desparately trying to find the right solution.
They are caught between a rock and a hard place but at least they can make the necessary decisions on monetary policy unlke us.
Our politicians have been sleeping for the last few years, falling at every hurdle to use the necessary fiscal policy to control our lofty assent and the best thing that our Taoiseach can do, when the going gets tough, is try to scapegoat the current problems on the people who highlighted these issues.
The Teflon Taoiseach strikes again! It’s not my problem its someone elses! He’ll take the credit for the good but not the bad!

“The world looks like it is going to be divided between countries that make hard stuff and countries that make paper money. The English-speaking world is in danger of being that part of the world that issues IOUs and prints paper money to pay for it.”

Part of the game was the historical pivotal role of the US President and Administration providing leadership and massaging the perception of strength, sense of purpose etc. that engendered willing followers in the rest of the world and hence the investment flow. The rest of the English-speaking world largely benefitted from this US-led cultural-military-economic complex. Now we are starting to realise how devasting the current US Administration is to our own economic well-being… and there is little we can do about it. The perception ain’t no more.

One of the neat little tricks that Greenspan did starting in 1994 was to redefine the CPI with “hedonic factors” and the like in order to conceal the real inflation rate, which has run around 2% annually over the “official” inflation rate since 1994. I left the U.S. in 1991 and returned in 2001. I was suprised at how expensive stuff was compared to 10 years previous. I noticed that the “official” inflation rate did not account for these price increases.

The economic growth from 1993-1997 was real. Many U.S. firms restructured and there was a lot of small-business lead growth. However, much of the “growth” since 1997 has been primarly asset inflation (equities in the late 90′s, real estate up until late last year) rather than real growth. Ironically, business, in general, really has gotten its act together about reducing corporate debt and ensuring healthy profitability. However, the same cannot be said about consumers (using inflated home equity to buy stuff, etc.) and the U.S. federal government finances are horrible.

I think the problem is centralized banking and centralized government control over the monetary system. The Federal government and the FED central bank are a form of monopolistic power over the monetary system. The FED (central bank) can get away with “redefining” inflation because it issues the fiancial data as well as sets the interest rate. Having these two functions by the same institution, the FED, is an unacceptable conflict of interest. First, the economic data can certainly be created by the ratings companies (Moody’s,. S&P, etc.), which would be an independent source of such data from the FED. Secondly, why should the central bank set interest rates in the first place? The market should be allowed to do this on its own. Then, throw in the political influence over economic policy by the Federal government, and you have the perfect moral hazard condition resulting from such abuse of fiat currency. Monopoly power is always a bad thing.

I am no advocate of a gold standard, but there should be a way to create a stable currency, of which the value thereof would be independent of governmental influences as well as that of a monopolisitic central bank. Perhaps having several central banks or group of banks each issue their own currencies may be one way to resolve the issue. The only role of government would be to enforce bank regulations to ensure that such private currencies do not go down the toilet because of moral hazard with such banks.

Instead of having a single central bank, might it not be better if you had several central banks

[...] and to continue my hegemony against the us, this Irish economist points out that the international community is pretty fed up with our economically retarded policies of borrowing more, spending more, and saving nothing. somebody needs to be saying it. bread and circus??? and in case you’re wondering, here’s what he means by two fingers. [...]

At first glance, it appears that the writer has his information wrong. Also, he is picking one auction out of several auctions, as there are Bills, Bonds and Notes auctioned by the Treasury.

There was no Bill Auction on the 15th. The 12th, the 18th. Issue dates that look like they could be the 14th or the 15th.

There are 4, 13, and 26 week Treasury Bills, each with it’s own auction. Finding a match to the auction he is discussing is impossible.

There was a Treasury *Note* auction on the 15th, where they auction off two kinds of Notes, a 10 year, and a 9year,11month (I have no idea how that works, something to do with interest already accumulated). The second, the tendered 20.4B in notes, got back $8B in notes. On the first, they offered $34.BB in notes, got back $17.5B

It also appears that the Treasury, on all instruments, consistently gets about 1/2 of what it tenders to auction pretty consistently.

Similiar Notes from July 2006, 17.5B/10.5B, 18.1B, 9.4B.

Not much deviation. I don’t want to totally call BS, as 2006′s Notes at 2.5% interest rate sold better than 2007′s 4.5% interest rate.

But he did pull one auction out of 16 that were held that month, none of which appear to deviate all that much from previous auction periods and declared a trend. There is no such thing as a Ten Year Treasury Bill. A Ten Year Treasury Note, yes. But there are important differences between Bills and Notes. Bills appear to cover short term debt, Notes cover long-term debt. He also called it a Bill auction when it was a Note auction. He also states that they offered 8Billion and only got a 10% hit, when it appears the Treasury tendered 20.4B and *got* 8Billion. Closer to a 40% hit. I have little to no argument with some of his other statements in the article…borrow less, spend less, save more are great mottos to live by. But his argument at the very beginning is inaccurate at best, and a complete misdirection at worst.

Actually, I am going to call BS on this.

I am more curious as to why the Treasury starting selling Bonds again last year after a 5 year hiatus.

I could also be reading all of this completely wrong, as I too don’t have financial wizardy in my brain. But, the cursory research seems to reveal…

It is my understanding that the treasury note *auction* on June 12 (issued June 15) was in fact an *auction*. Of the $8B offered $8B was sold, just at different prices, totalling slightly over $8B. The $20.4B figure was the total amount of all bids for the notes, only a portion of which were accepted.

The June 12th auction was of Treasury Bills, not Treasury Notes.
The Auction on the 15th was Treasury Notes.
These are not semantic differences, but two very different instruments.
Frankly, I’m still surprised that someone with the author’s apparent economics
background made such a fundamental error. As I stated above, it makes me suspect the rest of the article.

I work in the Bond market (non USD) and as J A Stone pointed out there are great flaws in this article. The suggestion that only 10% was taken up was news to me. J A Stone is also correct in that a 10 year US Treasury is a Note not a Bill.

I am a big fan of David’s work, but have to say this article disappointed me.

There is talk that Asian central banks and petro dollars are seeking to diversify out of US Treasuries.

[...] On June 15, the US government was given two fingers, not by a bunch of internationalist lefties, but by its main supporters, the international financial community. The US treasury tried to sell new US ten-year treasury bills worth $8 billion to plug the gap between what Americans spend and what Americans save. For the first time ever, foreigners said: ‘‘No thanks.” In doing so, foreign investors kicked off a process that has left the financial markets and the dollar in a tizzy. By taking up only 10 per cent of what the US government was trying to sell, investors have screamed: ‘‘The emperor has no clothes!” They are beginning to see through the Americans’ game. Since the beginning of the century, the US has been playing a big game of IOU with the rest of the world. Americans have been spending more than they are saving, and are asking the rest of the world to pay for the gap. In return, the US gives us a piece of paper which states that the American government will pay us back in 30 years. [...]

Hi Scruff and Stone! I think if you read David’s article a bit more carefully you would realise what he is saying, is that the people who were buying these Treasury Notes in recent times were Asian investors!. On this occassion the uptake of these issues was substantially down. ie the asians only purchase 10% of this issue the remaining amount was obviously purchased, if it wasn’t it would have made global headlines.
There was a recent article in the Economist that points this out too! I can’t get the link but it is worth checking out!
I too have access to view some of this data, I can see the issues and the volumes auctioned and amounts tendered. At this point there doesn’t seem to be any problems with the interest in the debt but there is an underlying trend that could be worrying.
I also read another article that if current trends relating to US treasuries persists they could be lowered to junk statue within 10-15 years. (I don’t believe this could happen, but there is some imbedded difficulties that need to be addressed and will be address but it could be economically painfull to sort out)

I’ve reread the article. No where within it does he mention the idea that asian investors backed off buying Treasuries. Unless there is some sequence of codewords that I’m totally missing.

I’m not actually attacking the basic premise of his article…that the US has gotten sloppy in its money management, and that the US is asking for a serious ass-kicking in the global securities market because of it. I am, however, questioning the underlying premises and “facts” that he references to get to his primary premise.

I also have access to the Economist. Please find your reference and post it.

Thanks for the clarity, and i did miss the point about Asian participation in the auction. Stone does have a point about the article being a little sensationalist. I think it’s a bit early to say that Asian central banks have lost their appetite for Traesuries. There are few markets in the world that are deep enough for these Banks to “get set” in size.

Thanks very much for all your comments. Scruff and Stone my apoligies, the data I was working on was taken from a piece I read in a credible journal *the Dines Newsletter* – an extremely thoughtful publication – about the difficulties the treasury was having in selling paper to foreign investors, particlarly Asians. The issue is the constant flooding of the world financial markets with US paper money, coming back to Kurt9′s point about “non-tradable” asset price inflation in the US and the wisdom of the present monetary arrangements. I see the same delinquency occuring here in Ireland on a weekly basis as we flood our economy with borrowed paper money which is driving up prices, making us less competitive and enfeebling us in the process. The US is our model – for all the right reasons – it is also our best friend, but you know what they say about friends..its only your mates will tell you the truth. I take the same approach when I see you guys point out my sloppy research. Thanks for keeping my on side and thanks for all the comments. Best David

Hi J A, the article “not so risk-free” was in the economist on the 16/06/07, its an interesting one!
I do agree that the article above is a bit sensationalist but then again we probably wouldn’t read it if it wasn’t!

Hi
All this stuff about the world about to collapse in on the “Anglo-Saxon” world is just too pessimistic. After all, I do remember hearing similar prognoses around Reagan’s time, until the Clinton era balanced the books again. The current dollar weakness is associated with a whole series of factors, such as the stock market crash post-2001, the FED reaction to that crash of introducing very low interest rates, then the Bush tax giveaways, the spending on the Iraq war, and so on. All of these contributed to a low interest environment followed by asset price bubbles. But the American economy is still the powerhouse of the world and will be for some time to come.
So China has an Intel factory? Good. But only the manufacturing is done by Chinese workers and the profits go back to the USA (and Intel share-holders). The same goes for all those foreign companies setting up in China – like Nokia. The wealth is shared between the low-paid Chinese workers (the minority of it) and the profitable intellectual rights-holders (the majority of it).

Wealth is more than about manufacturing. The “Anglo-Saxon” world still produces the ideas and culture that powers the world economy – from Microsoft, to Dell, to Intel, Google, to Pfiser, the US owns the copyright on high technology. When China starts producing original ideas and technologies that conquer the world, that is when to worry!

America was finished in 1973, the day Nixon took us off the gold standard. This enabled the Federal reserve to invent wealth and buy oil by printing dollars. Now we have so many USD in circulation, the only thing that makes them worth any value is America’s military threat…and the naive stupidity of the American people who still think that the U.S. is the center of the universe.

America is bled-dry of any net worth or value. Once America can no longer bleed the rest of the world of its money and resources, she will collapse upon herself not unlike the Roman empire.